LP L FINANCIAL

2 0 09ROUT
E S E AR
L OOK
CH

Outlook Lincoln Anderson

Managing Director, Chief Economist
Chief Investment Officer
Burt White
Managing Director
Director of Research
Jeffrey Kleintop, CFA
Senior Vice President
Chief Market Strategist
Anthony Valeri, CFA
Senior Vice President
Fixed Income Strategist
John Canally, CFA
Vice President
Investment Strategist
John Guthery, CFA
Vice President
Alternative Investment Strategist

Table of contents
2-5 2009 Outlook
What’s on the Horizon
2009 Outlook at a Glance

6 - 18 Chapter 1
How We Got Here & Where We Are Headed

19 - 22 Chapter 2
Great Depression II? Why It Is Highly Unlikely

23 - 27 Chapter 3
Impact of Change in Washington
 2 0 09 OUT L OOK

2009 Outlook
What’s on the Horizon
Every year LPL Financial Research compiles its
Outlook for the following year to let investors know
where we believe the markets are heading and
how to best position portfolios. The heightened
uncertainty and conditional nature of the current
macroeconomic and policy backdrop generated a
wider range of possibilities for 2009 than for most
years. As a result, we present three scenarios for
2009, our base case, a bear case, and a bull case.

Three scenarios for 2009 include our base case, the scenario we believe
to be most likely, a bear case or continued downturn, and a bull case or
market rebound.

1. Base Case
The financial panic that began in September 2008
will subside in early 2009 allowing a normalization of
financial markets by mid-year 2009.
Why would the base case prevail?
„ Intervention policies implemented by the U.S. government begin
to take effect.
„ Market sentiment remains cautious through volatile January markets.
„ Consumers remain cautious after a dismal 2008 holiday sales season.
„ Unemployment remains relatively high through much of the first half of
the year.
The base case scenario:
„ The economy emerges from recession in the second half of 2009.
„ Inflation turns negative early in 2009, but rises by the end of the year.
„ The stock market, as measured by the S&P 500, posts a return in the
mid-teens, as a volatile first half of the year gives way to more consistent
improvement in earnings and sentiment in the second half. We anticipate
the year-end S&P 500 close to be around 1000-1050.
„ The bond market, as measured by the Barclays Aggregate Bond Index,
posts a return in the mid- to high-single digits range.
„ In alternatives “volatility thriving” strategies continue to benefit returns in
the first part of the year.

2. Bear Case
The financial panic lingers well into 2010, and financial
markets do not normalize at all over the course of 2009.
Why would the bear case prevail?

2
 2 0 09 OUT L OOK

„ Foreign bank failures continue without the type of intervention seen in

the United States.
„ Housing sales break down from the stable levels of the past year and
follow the path of auto sales sharply downward.
„ Increasingly aggressive forced selling by financial institutions or a major
negative geopolitical event further disrupts the markets.
The bear case scenario:
„ The economy lingers in a recession throughout 2009 and into 2010 with
a frozen lending market.
„ Stocks post another year similar to 2008, marked by a possible 35%
decline as confidence fails to return and earnings tumble another 20%.
The year-end S&P 500 close would be about 560.
„ Bonds return low- to mid-single digits, with additional Treasury gains
offset by price weakness in non-Treasury sectors: Corporate Bonds,
Mortgage-Backed Securities (MBS), and Agency Bonds.
„ The alternative investment areas of opportunity are: Long/Short, Covered
Calls, Managed Futures, Global Macro, Absolute Return, and Market
Neutral—all those strategies that help with volatility.

3. Bull Case
The financial panic that began in September 2008
dissipates at the very start of 2009, and financial markets
begin to normalize early in the year.
Why would the bull case prevail?
„ Evidence of a sharp rebound in market sentiment comes in late 2008 or
early 2009.
„ Policy actions take effect sooner than expected.
„ Falling mortgage rates help to deliver a bottom in home prices.
„ The Federal Reserve (the Fed) injects more capital into financial
institutions, and lending accelerates.
The bull case scenario:
„ The economy experiences a quick rebound from the recession and a
rebound in the credit markets as confidence is restored.
„ Stocks rebound up to 50%; both earnings and valuations snap back as a
mountain of cash is returned to the capital markets. The year-end S&P
500 close would be about 1365.
„ The bond market returns high-single digits as income and price
appreciation, from Corporate Bonds in particular, more than offsets
Treasury weakness.
„ Most alternative strategies provide positive results but trail the strong
stock market in this bullish scenario.
Under all of these scenarios, the outcome of the 2008 elections creates
heightened uncertainty for business leaders and investors about changes
affecting the business climate. We expect changes to the investor tax cuts of
2003, among others, to impact investors in 2009.

3

2009 Outlook
Outlook At A Glance
BASE CASE
ECONOMY
FORECAST Financial panic subsides in early 2009
„ Recession ends mid-year
„ Unemployment rate rises to
8%-9%
„ Inflation will turn negative early
in 2009, but rise by the end of
the year
„ Home prices fall another 5%
PORTFOLIO CONSTRUCTION - Relative to Strategic Weights
„ First half: Overweight alternative
asset classes, slight underweight
to stocks and bonds
„ Second half: Trim alternative
asset classes, neutral to slight
overweight to stocks and neutral
to bonds
EQUITIES
FORECAST „ S&P 500 posts mid-teen returns
„ S&P 500 EPS is likely to be about
$80, or up only about 7% from
2008
„ P/Es go to 12 by year-end
MARKET CAP Underweight Large Caps relative
to strategic weights in the first half
of the year
„ Larger Cap stocks are not as
dependent on credit
„ Small Cap stocks will benefit from
easing credit conditions and less
international exposure
STYLE Overweight Growth relative to Value
„ Growth stocks outperform Value
stocks when valuations are rising
„ Growth stocks are more defensive
than Value stocks
U.S. VS. Overweight U.S. relative to
INTERNATIONAL International
„ International markets are lagging
the U.S. in terms of policy stimulus
„ Deeper linkages between banks
and businesses will cause the
international recovery to be slower
and weaker than the U.S.
„ International stocks are more
value oriented
4
BEAR CASE
Financial panic lingers
„ Recession extends
throughout 2009
„ Unemployment rate rises past 10%
„ Deflation intensifies leading to
stagflation into 2010
„ Double-digit home price declines
„ Underweight stocks
„ Overweight alternative
asset classes
„ Overweight conservative bonds
and cash
„ The S&P 500 posts a 35% decline
„ S&P 500 EPS to plummet another
20% to about $58
„ P/Es go to 8 by year-end
Overweight Large Cap
„ Large Caps are more defensive
than Small Caps
„ Underweight cyclicals and
Small Caps
Overweight Growth relative to Value
„ Defensive Growth stocks hold
up better
Overweight U.S. relative to
International
„ International stocks are more
value oriented and therefore
less defensive
„ Key value sectors like Financials
negatively impacted by lingering
financial panic
2 0 09 OUT L OOK
BULL CASE
Financial panic subsides at start
of year
„ Economy rebounds in first half
of 2009
„ Unemployment rate peaks at
7%-7.5%
„ Inflation rises as oil rebounds
„ Home prices begin to rise
by mid-year
„ Overweight stocks
„ Underweight bonds
„ Underweight alternative
asset classes
„ The S&P 500 posts a 50% gain
„ S&P 500 EPS increases to
above 20%
„ P/Es rise to 13 a 50% rise from its
current level
Overweight Small Caps relative to
strategic, slight underweight of Large
Caps relative to strategic
„ Small Caps outperform during the
beginning of the business cycle
and offer more market beta
Overweight Value relative to Growth
„ Overweight cyclicals
„ Underweight defensive
„ Overweight high beta
Overweight International relative
to strategics
„ International stocks are more
value oriented and therefore
more cyclical
„ As investors move away from
the safe haven of the U.S., the
dollar return on international
investments rises

2009 Outlook
Outlook At A Glance (continued)
BASE CASE
FIXED INCOME
FORECAST „ High Quality Bonds return mid- to
high-single digits
„ High Quality Corporate Bonds
and Mortgage-Backed Securities
outperform U.S. Treasuries
„ Municipal Bonds remain cheap to
Treasuries but improve in second
half of 2009
DURATION Remain duration neutral
„ Better risk-reward lies in sector
bets than in interest rate bets
SECTOR Favor Corporates, Agencies,
Preferred Stocks, and MBS over
Treasuries
„ Yield advantages in spread sectors
are notable
„ Higher quality spread product will
likely benefit first
U.S. VS. Favor International over U.S.
INTERNATIONAL „
Foreign banks have more rate cuts
than the Fed left to make
ALTERNATIVE INVESTMENT MUTUAL FUND STRATEGIES
FORECAST „ Volatile markets prevail in the first
half of the year
„ Alternative investment strategies
outperform during the first half of
the year, but underperform as the
markets rebound in the second half
POSITIONING Overweight volatility thriving and risk Overweight volatility thriving and risk
management strategies in first half of management strategies throughout
VOLATILITY the year and migrate to opportunistic the year
THRIVING: strategies in the second half
Covered Call,
Managed Futures,
„ Use strategies that manage
risk and returns when markets
Global Macro
go up and down for the first half
RISK of the year
MANAGEMENT: „ As the economy recovers, migrate
Long/Short, Market to opportunistic strategies that
Neutral, Absolute help with economic distress such
Return as Distressed Debt
OPPORTUNISTIC: „ Continue to avoid economically
Distressed Debt, sensitive opportunistic strategies,
REITs, Commodities such as REITs and Commodities
until later in the cycle
BEAR CASE
„ High Quality Bonds return low- to
mid-single digits
„ Treasuries continue outperformance
relative to Corporate Bonds and
Mortgage-Backed Securities
„ Municipal Bonds underperform
Treasuries and municipal yields
rise on credit quality concerns
Lengthen out duration
„ Lower yields and rising prices
are more pronounced for longer
maturities
Favor Treasuries
„ Explicit government backing is
necessary
„ Avoid High Yield Bonds,
investment-grade Corporate
Bonds, and Preferred Stocks
Favor U.S. over International
„ More uncertainty remains with
what foreign banks will have to do
„ Volatile markets prevail throughout
the year
„ Alternative investment strategies
continue to outperform relative to
equities, but underperform relative
to fixed income
„ Volatility thriving and risk
management strategies provide
greatest relative outperformance
throughout the year
„ Continue to avoid economically
sensitive opportunistic strategies,
such as REITs and Commodities
2 0 09 OUT L OOK
BULL CASE
„ High Quality Bonds return
high-single digits
„ Corporate Bonds lead
performance by wide margin
and Treasuries lag among
domestic sectors
„ Municipal Bonds outperform
Treasuries and get added boost
late in 2009 on prospects of higher
tax rates
Shorten duration
„ Focus on more eclectic fixed
income sectors, not duration
Favor High Yield Bonds,
investment-grade Corporate
Bonds and Preferred Stocks
„ Quickly improving credit markets
favor higher beta spread product
„ Avoid Treasuries
Favor International over U.S.
„ Unhedged outperform hedged due
to dollar weakening
„ Volatility subsides
„ Equity markets rally
„ Alternative investment strategies
underperform relative to equities
but provide opportunities relative
to fixed income
Overweight opportunistic strategies;
underweight volatility thriving and
risk management strategies
„ Strategies that help with
volatility and risk management
underperform relative to equities
„ Overweight opportunistic
strategies such as Distressed Debt
„ Overweight to opportunistic,
economically sensitive strategies
such as REITs and Commodities
5

Chapter 1
How We Got Here & Where We Are Headed
Oil Prices
Amid the growing financial crisis, rising
commodity prices were bearing down on
the economy. Soaring oil and commodity
prices weakened the U.S. economy in
the first half of 2008. Oil doubled in price
from a year earlier and peaked during the
summer at $147 per barrel. This pushed
gasoline prices over $4 per gallon and
sapped consumer spending power. The
subsequent collapse in oil and other
commodity prices wreaked havoc among
a number of hedge funds causing some
to fail and destabilized some emerging
market nations resulting in dramatic
declines in the stock markets of oil
exporters like Russia.
6
HOW WE GOT HE R E
In order to know where we are headed, we need to
know how we got here. 2008 has been a tumultuous
year but the seeds were planted years ago.
Appreciating how policies and motivations have
changed over time can help us better understand
how the market collapse and recession came about.
How We Got Here
1. Industry changes that led to a lack of oversight and regulation over a
number of major financial institutions.
2. Drastically lowering lending standards without recalibrating risk
assessment tools.
3. Financial institutions increasing leverage to inappropriate levels and their
dependence on the capital markets.
Over the last 10 years, legislative changes transformed the financial services
industry. The Gramm-Leach-Bliley Act of 1999 effectively repealed the Glass-
Steagall Act of 1933. This Great Depression era act had separated lending
(the extension of credit) from investing (the use of credit), after combining
both activities in the same financial services entity had led to abuses that
threatened the safety of deposits. The 1933 act’s repeal in 1999 allowed for
consolidation between commercial banks, investment banks, and insurance
companies, and blurred the distinctions between these lines of business
and their regulatory oversight.
The result was an increased incentive for banks to provide loans, bundle
loans into complex housing-related investments, and then buy, hold, or trade
these newly created securities. At the same time, relatively low interest
rates set by the Federal Reserve Bank and other Central Banks following
the 2001 recession triggered a boom in housing activity. Consequently,
the typical home price rose from about 3.5 times household income to
5.0 times income by mid-2006. Financing from the investment banks was
abundant, mortgage rates were low, home prices were rising, and volume
was the key driver of profits. So, lending was extended to less credit-worthy
borrowers than traditional mortgage lending would have approved, as
innovations in structured finance broadened the appetite for mortgage debt
in a yield-hungry marketplace.
Tight credit spreads forced investment banks to use high amounts
of leverage through debt issuance in order to reach profit targets on
investments. To illustrate the problem, consider that a homeowner would be
leveraged 5-to-1 with a purchase of a home with 20% down payment and
an 80% mortgage. If the price of that home declined 10%, the mortgage
would stay the same and the value of the homeowners’ equity would be
cut by 50%. Some investment banks were leveraged 20-to-1 or even 30-
to-1 on housing-related investments, but continued to rely on quantitative
tools that used historical inputs to measure risk on them. The historical
 HOW WE GOT HE R E

data underrepresented the actual potential losses these new types of

investments could bring to those inside and outside these institutions. Housing Valuations Returning to Normal
When this value is rising, home buyers are paying
The inappropriate use of leverage will go down in history in 2008, as it did in more for their homes relative to their income.
1929, as one of the villains of the market crisis. Some hedge funds that use Median Home Price Divided by Median Household Income
leverage got caught over-levered, and these funds, along with investment 5.5
banks, individuals, and institutions, all played a role in levering our markets
5.0
to a point of irresponsible risk.
4.5
The changes among financial institutions made investment banks more
dependent upon borrowing from other banks to fund investments, whereas 4.0

in the past funding relied more upon commercial bank deposits. This 3.5
borrowing made many of the banks incredibly interdependent and securities
highly intertwined. As prices began to slide, investment banks became 3.0

unable to raise funds from other banks in the interbank market and were 2.5
forced to sell their investments. Because the investment banks made up a 1978 1982 1986 1990 1994 1998 2002 2006 2010
large portion of the demand for these securities in recent years, there were Source: LPL Financial Research, Bureau of the Census,
few buyers to absorb the supply, which accelerated the decline in the value National Association of Realtors.
of the securities. The prices of housing-related securities entered freefall.
The Fed’s surprising decision to let Lehman Brothers fail caused interbank
lending to suddenly seize up in September. With banks unwilling and unable
to lend to each other, the markets went into a tailspin and the previously
undiagnosed recession intensified and became apparent.
The Fed and Treasury have responded with enormous and unprecedented
policy actions to thaw the financial markets and restore funding to financial
institutions. These include making more than $1 trillion available by:
„ Directly injecting capital into embattled institutions (the Troubled Asset
Relief Program or TARP).
„ Opening credit facilities available to banks and other financial institutions
(Fed Primary Dealer Credit Facility or PDCF).
Credit Default Swaps
„ Creating the commercial paper program to lend directly to businesses. The failure of Lehman Brothers and
rescue of AIG in mid-September of 2008
„ Directly purchasing Mortgage-Backed Securities and loans. led to a blow up of the credit default
„ Providing explicit guarantees of the liabilities of a few financial institutions swap market. Credit-default swaps are
including AIG and Citigroup. financial instruments based on bonds
and loans that are used to speculate on
Intervention by policy makers has historically marked the turning point for bear a company’s ability to repay debt. They
markets and limited the duration of recessions. While this financial crisis is pay the buyer face value in exchange
more severe than most, the scope of the policy response is unprecedented. for the underlying securities or the cash
And while key policy actions are taking time to implement, we believe the equivalent should a borrower default. A
trillions of dollars being marshaled to stabilize the global financial markets rise in the CDX North America Investment
are likely to prove to be successful. Indeed, signs of progress evident in Grade Index, which tracks 125 companies,
late 2008 include a sharp fall in interbank lending rates, stabilizing credit indicates declining confidence in these
spreads, and the return of the commercial paper market. However, many companies’ ability to repay debt. After
potentially negative unintended consequences stemming from these ranging between 1% and 1.5% prior to
unprecedented policy actions create a lot of uncertainty as we enter 2009. mid-September 2008, the credit-default
These consequences include the impact of sweeping regulatory changes, swap spread on the index broke out of
political oversight, more conservative consumer financing, the ongoing the range to the upside and continued
deleveraging of financial institutions, and the potential for rising inflation as to rise to about 2.75%. The proliferation
growth resumes. of these financial innovations introduced
additional credit exposure to financial
institutions such as insurance companies
and exacerbated the financial crisis.

7

Key Gauge of Crisis Now Showing Signs of Easing
5.00
3 month U.S. LIBOR Less 3 Month Treasury Bill Yield
4.50
4.00
3.50
3.00
Percent
2.50
2.00
1.50
1.00
0.50
0.00
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov
Source: Bloomberg, LPL Financial Research
LIBOR: The London Interbank Offered Rate is a measure of the
cost incurred by banks when borrowing from each other. As
competition for limited funding increases, the rate rises.
Which of our past recessions
does the current recession
most resemble?
We expect that the current recession,
which began in December 2007, will
linger until mid-2009 and end up being
the worst recession in terms of duration
and severity. Our view is that while the
recession technically began in December
2007, the recession intensified and
went “global” in mid-September 2008
in the wake of the collapse of Lehman
Brothers, which led to a seizing up of
global credit markets. The 1973-75 and
the 1981-82 recessions lasted 16 months
each, the longest duration for post-World
War II recessions. (The average post
war recession lasted just 10 months.)
The unemployment rate, a proxy for the
severity of a recession, peaked at 9.0%
(from a low of 4.6%) just after the end
of the 1973-75 recession, and peaked at
10.8% late in the 1981-82 recession, up
from the pre-recession low of 5.6%.
8
B AS E C AS E
Where We Are Headed?
Three Potential Scenarios for 2009
The range of possibilities for 2009 is wider than for most years, given the
heightened uncertainty and conditional nature of the macro economic and
policy backdrop. We believe there will be an overall gradual improvement in
conditions in the credit markets and economy in 2009. But rather than present
one base case that we believe has the highest probability of occurring, we
have opted to also explore two other paths that 2009 may follow.
1. Base Case
Key premise: The financial panic that began in
September 2008 subsides by early 2009, allowing a
normalization of financial markets by mid-year 2009.
Economy
Economic Backdrop Assumptions:
„ Recession status: The U.S. economy emerges from the recession—that
officially began in December 2007—sometime in the second half of
2009. The U.S. Gross Domestic Product (GDP) contracts by at least 5%
in the fourth quarter of 2008, as consumers retrench and U.S. exports
dry up amid the dramatic slowdown in overseas economic activity. We
expect that real GDP growth in both the first and second quarters of
2009 will be negative—close to the fourth quarter 2008 decline in the
first quarter, and less negative in the second quarter. We expect real
GDP growth to be roughly flat in the third quarter of 2009 making this
the longest and deepest recession in the post-war period. We expect
that the economy will begin to emerge from the recession in the fourth
quarter. However, GDP growth remains choppy and well below the
economy’s long-term potential growth rate, which keeps pushing the
unemployment rate higher.
„ Inflation: As measured by the Consumer Price Index (CPI), headline
inflation turns negative early in 2009, but rises by the end of the year.
Core inflation—inflation excluding the impact of food and energy
prices—continues to move lower over the first half of 2009, but then
stabilizes and begins to move higher in the latter part of the year as the
Fed grows the money supply (reflation).
„ Unemployment: The unemployment rate rises from 6.7% (as of November
2008), maxing out between 8% and 9% in late 2009 or early 2010.
„ Home prices: Housing prices decline nationally roughly another 5% in the
first half of 2009, but bottom at mid-year as low rates and the increased
availability of credit spur buying.
„ Oil: Oil prices bottom near $30, then stabilize in a $30 to $50
range in 2009.
„ Dollar: The US dollar continues on an upward path, rising another 10% or
so in 2009.
Federal Reserve Actions:
„ Target interest rate: The Fed maintains near zero effective fed fund rate.
 B AS E C AS E

„ Balance sheet: The Fed continues to make capital injections into U.S.
corporations, mainly financial institutions, as needed. As rates approach
zero, the Fed is likely to continue to take on troubled assets and issue
government securities (known as a balance sheet expansion program) as
it attempts to reflate the economy.
„ Money supply: The Fed’s reflation policy will sharply increase the money
Unemployment Insurance
Despite a small drop in the latest week, jobless claims
remain at their highest level since the 1981-82 recession.
Unemployment Insurance: Initial Claims, 4-wk Moving Avg
Unemployment Insurance: Initial Claims, State Programs
700

supply by late 2009.

600
Government Actions:

In Thousands
500
„ Stimulus package: A fiscal stimulus package that equates to between
2% and 4% of GDP passes early in 2009. The package will be aimed 400
at infrastructure, but the bill will also contain more traditional forms
300
of stimulus, such as the extension of unemployment benefits and job
training programs, among others. A middle class tax cut—possibly 200
coupled with tax increases for taxpayers in the upper brackets—is 85 90 95 00 05
passed as part of the stimulus program. Source: Department of Labor / Haver Analytics 12/08/08
„ Budget deficit: The U.S. budget deficit will rise to more than $1 trillion in
2009, or roughly 7% of GDP.
„ Other measures: The remaining $350 billion of the funds authorized by
Congress in October 2008 as part of the TARP is likely to be spent aiding Unemployment Rate Typically Peaks
more “Main Street” finance like student and auto loans. Some kind of Close to the End of Recessions
The unemployment rate is headed higher in 2009.
direct housing relief is implemented in early 2009 (likely establishing a
Civilian Unemployment Rate
set mortgage rate for traditional loans to all new buyers and refinancers 12
alike). Tax rates on dividends and capital gains move higher, but not until
the end of 2010. 10

Equity Markets
Percent

At year-end 2009, we anticipate the S&P 500 index will be at around 1000 or 6
1050. The rise to this level would be driven by a price-to-earnings ratio (P/E)
of 12 on the next 12-months expected earnings per share (EPS) of about 4
$88 in 2010 and a dividend yield of 3% to 4%. For context, this would be the
2
level at the top of the range of the S&P 500 since mid-October 2008. Details
75 80 85 90 95 00 05
follow about how we reached these values for the three component parts of Source: Bureau of Labor Statistics / Haver Analytics 12/02/08
S&P 500 total return: EPS, P/E, and dividend yield.
Earnings per share (EPS): As credit markets improve and the economy
emerges from recession, earnings growth is likely to rebound. As a result
of the contributions of the various sectors, EPS in 2009 is likely to be about Core and Headline Inflation
$80, or up only about 7% from 2008. By way of comparison, the Thomson Both headline and core inflation set to slow in early 2009,
Financial-tracked Wall Street analyst consensus for EPS in 2009 is in the mid- but inflation could return towards the end of 2009.
$80s—that is a consensus forecast for an increase of about 15-20%. Our Year-Over-Year Change in Core Inflation
Year-Over-Year Change in Headline Inflation
estimate of the four quarter sum of EPS in 2009 is for about $80, which will 15.0
leave 2009 well below the mid-2007 peak of $92. A tough next few quarters
for earnings, combined with a relatively shallow recovery in the economy 12.5

beginning in mid-2009, would take EPS to about $88 in 2010 as the U.S. 10.0
Percent

economy more fully emerges from recession. The potential 10% gain in
EPS to about $88 in 2010 is only half of the average 20% gain in the year 7.5

following a recession owing to the lingering impact of deleveraging. 5.0

In 2008, S&P 500 operating EPS were down about 20% from their peak in 2.5
mid-2007. The largest factor pulling down overall EPS was Financials sector
0.0
companies. Therefore, a key component of an earnings growth rebound
75 80 85 90 95 00 05
is what happens with the Financials sector. The likely rebound in earnings Source: Bureau of Labor Statistics / Haver Analytics 12/03/08
from the Financials sector in 2009 comes in part from the impact of the

9
 B AS E C AS E

different mix of companies from those that comprised the index for much
U.S. Budget Deficit
of 2008. Many of the companies that made up a large portion of the index
U.S. facing the worst budget deficit as percent of GDP
at the end of 2008 had more defensive sources of revenue and are likely to
since World War II
experience much lower write-down amounts than those that comprised the
4.0 index at the beginning of 2008. Without the impact of the outsized losses
2.0 from the failed investment banks that took place in 2008, combined with
the actions of the Fed and Treasury to stem losses elsewhere, earnings
0.0
growth will rebound for the sector. However, this rebound will be partially
Percent

-2.0 offset by weakness overseas; S&P 500 companies derive about 40% of
their revenue from non-U.S. markets.
-4.0
Price-to-earnings ratio (P/E): The level of the S&P 500 at the end of 2009 will
-6.0
be dependent upon the confidence in the outlook for earnings in 2010. We
-8.0 anticipate valuations rising from the current price-to-earnings ratio of 9 on
62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 09E
the next 12 months S&P 500 EPS to 12 as of year-end 2009. This valuation is
Source: Bureau of Labor Statistics / Haver Analytics 12/03/08
shy of the long-term average of 15, as fears of inflation loom and uncertainty
lingers despite the start of a modest mid-year economic and EPS recovery.
The rebound in valuation is contingent upon confidence returning as credit
markets begin to heal, mortgage-related debt values stabilizing, home
prices stabilizing after a further decline of about 5%, and market participants
anticipating an economic and earnings rebound taking place in the second
half of the year. Prior to 2008, the last time the S&P 500 traded as low as
12 times expected earnings was in 1994, when the uncertainty surrounding
the so-called “jobless recovery” from the 1991 recession, combined with
the perceived threat of sweeping legislative and regulatory changes to the
healthcare industry, pulled down valuations. The uncertainty of the political
and economic environment of 2009 may result in a similar valuation. A
potential percentage gain in the index in the mid-teens for 2009 is well
below its typical rebound from a recession, which typically runs between
25% and 30% in just the first 90 days.
Dividend yield: The dividend yield on the S&P 500 will likely be in the range
of 3% to 4% in 2009. The dividend yield may remain above the yield on the
10-year Treasury note for much, if not all, of the year, a rare occurrence. The
S&P 500 dividend yield has not been above the 10-year Treasury yield for 50
years—in 1958 the 10-year Treasury yield was around 3%, and the dividend
yield on the S&P 500 was around 4%, similar to today.
International equities: International markets are likely to lag the United States
again in 2009 as the deeper and longer recession takes hold overseas and
the US dollar strength continues. While we believe the policy actions by the
Treasury and the Fed will begin to cure the financial crisis in the U. S., we are
not so optimistic on the measures being taken abroad to treat the symptoms
of the crisis, much less provide the cure. The economies of Europe may lack
some of the tools and resources to address the crisis effectively, and Asian
economies are suffering from falling export growth, driving those economies
deeper into recession.

Fixed Income Markets

We expect a choppy bond market where improvements in non-Treasury
Bonds, big laggards in 2008, are met with selling and potential retests of
record low valuations established in the fourth quarter of 2008. We expect
bond performance, as measured by the Barclays Aggregate Bond Index, to
range from mid- to high-single digits for 2009, based on the assumptions
of Treasury yields declining by 0.25% then rising by 1.00% later in the year
and of modest spread contraction among Corporate Bonds, Agency Bonds,

10
 B AS E C AS E

and Mortgage-Backed Securities (particularly Agencies). As these spreads

contract, yields on non-Treasuries fall, causing their prices to rise. In 2008, Fixed Income Excess Returns
investors became risk averse—flocking to Treasuries which have become Barclays Aggregate Bond Index Excess Return
very expensive (meaning they have low yields). As we move further into and Duration Adusted performance vs Treasuries (%)
6
then out of this recession during 2009, we anticipate that investors will be
4
more willing to take on some risk—as long as they are paid for it—and move
2
away from Treasuries to other spread products (Corporate Bonds, Agency
Bonds, Mortgage-Backed Securities (MBS), High Yield Bonds, Foreign Bonds, 0

Bank Loans, and Municipal Bonds). -2

-4
Given the preponderance of cheap assets in the spread product sectors of
-6
fixed income markets, we believe that investors will be drawn first to the
-8
high grade sectors—Corporate Bonds and MBS—before migrating down
-10
the credit quality spectrum to lower grade bonds, such as High Yield or Bank
12/1990 12/1993 12/1996 12/1999 12/2002 12/2005 YTD 2008
Loans. While we find valuations for both of these lower grade products Source: Barclays Capital / LPL Financial Research
attractive, we believe higher quality bonds will improve first. More detail
follows on each of the market segments.
Treasuries: We expect Treasury valuations to remain historically expensive
as bond investors monitor the degree and depth of the recession and falling Barclays Corporate Index Yield Spread to Treasuries
inflation in the beginning of 2009 keeps real yields well below the historical As the yield spread rises, yields of non-Treasury bonds are
average of 3.0%. Treasury yields will likely remain near historical lows over increasing, meaning that their prices are falling. In general,
the first half of 2009, before economic improvement begins to exert upward this causes the returns on individual bonds to fall.
pressure on yields later in the year. Liquidity is the key to improvement for 700

non-Treasury bond sectors. Liquidity is likely to remain constrained over the 600
first three to six months of 2009, despite unprecedented Treasury and Federal
Yield Spread (basis points)

500
Reserve support packages. Banks and other financial institutions will continue
400
to rebuild balance sheets during these months and limit participation in fixed
income markets. Illiquid markets exacerbate the impact of forced liquidations. 300

Although we believe the bulk of deleveraging is behind us, additional forced 200
sales are certainly possible and would support our expectation of a choppy 100
market, with Treasuries retaining a safe haven premium.
0
Corporate Bonds, Agency Bonds, and MBS: As banks and financial institutions
Dec-90
Dec-91
Dec-92
Dec-93
Dec-94
Dec-95
Dec-96
Dec-97
Dec-98
Dec-99
Dec-00
Dec-01
Dec-02
Dec-03
Dec-04
Dec-05
Dec-06
Dec-07
Dec-08
recapitalize, they will gradually increase market participation by taking
down more inventory and facilitating trading over the second half of 2009. Source: Barclays Capital / LPL Financial Research
This process will occur slowly but lead to slightly narrower yield spreads
for Corporate Bonds, Agency Bonds, and Mortgage-Backed Securities,
which together account for 73% of the Barclays Aggregate Bond Index.
Narrower yield spreads relative to the index would fall more in line with High Yield Spreads and the Default Rate
historical averages. Investors are paid more (the High Yield spread) when the risk
level of default (the default rate) is rising. The key is to find
Although we expect limited spread contraction, we still expect non-Treasury the point where there is more spread than actual—as
sectors to outperform due to their income advantage. Investment-grade opposed to anticipated or priced in—rate of default.
Corporate Bond yield spreads relative to Treasuries remain close to record
Default Rate (left hand scale)
wide levels. Using Barclay’s index data, the average investment- grade rated Yield Spread (right hand scale)
Corporate Bond yielded over 6% more than comparable Treasuries. The 20 2000
18 1800
previous record wide level in investment grade Corporate Bond yield spreads 16 1600
was 2.7% back in 2002. Not only are Corporate Bond yield spreads wide, but
Default Rate (percent)

14 1400
also overall yields are their highest since the early 1990s. MBS yield spreads
Basis Points

12 1200
10 1000
remain well above their 10-year average of 1.2% after having contracted from
8 800
record wide levels, a direct benefit of the Fed’s recently announced $500 6 600
billion MBS purchase program. With Treasury yields still at historic lows and 4 400
the Fed MBS purchasing program yet to begin, we expect the sector to be 2 200
0 0
well supported and continue to benefit. MBS pose an attractive high quality
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008

bond option for investors.

Source: Moody’s / Barclays / LPL Financial Research

11

What should investors do
if they believe the base
case will unfold in 2009?
The policy actions discussed, as part of
the Base Case, are very likely to limit the
duration and depth of the recession and
turn the stock and credit markets around
after a record-breaking plunge. However,
lingering uncertainties remain surrounding
the unintended consequences of the
policy actions, which are likely to foster
a high volatility environment and may
warrant a shift in some portfolios. The
focus on whether markets will go up OR
down is misplaced—they will go up AND
down. Rather than a period of rising or
falling markets, we will continue to be in
a bull market for volatility until financial
markets normalize in mid-2009. These
conditions place a premium on adaptation
and magnify the potential rewards from
effective tactical decision making during
the beginning of 2009. Alternative
investments that help with market
volatility, such as Global Macro funds
and Covered Call mutual fund strategies,
are likely to be increasingly effective at
helping manage risk and return.
We continue to favor U.S. markets over
international and Emerging Markets.
Minimizing exposure to foreign markets
proved to be valuable in 2008. With less
policy stimulus in the pipeline overseas
and deeper linkages between banks and
businesses, we expect the recovery
will be slower and weaker than in the
United States. We also favor Growth over
Value among Large Cap stocks. Growth
stocks tend to outperform Value during
periods when valuations are rising. We
expect valuations to drive much of stocks’
performance in the coming months as
investors reassess market risk premiums
while earnings weakness lingers.
In fixed income markets, we remain
duration neutral with an emphasis on
intermediate bonds as a better risk/reward
relationship lies in sector allocation rather
than taking interest rate risk. Our focus
remains on non-Treasury sectors, where
underperformance in 2008 has left spread
sectors at historically cheap valuations.
[Continued on page 13]
12
B AS E C AS E
High-Yield Bonds: The High Yield market has priced in a substantial rise in
defaults. We expect default rates to reach Moody’s year-end 2009 forecast
of 11.2%, roughly in line with the 2002 peak in default rates. With a current
yield spread of 21.8% above comparable Treasuries, the High Yield market has
priced in a rise in defaults to approximately 20%.
Foreign Bonds: Foreign Bond yields are likely to be stable or decline further.
Overseas central banks, most notably the European Central Bank (ECB) and
Bank of England, are behind relative to the Fed in terms of cutting interest
rates and will likely continue to cut interest rates even after the Fed is done.
Although rate cuts are priced in, the possibility of greater than expected rate
reductions should make high quality Foreign Bonds look more attractive than
their U.S. counterparts and support high quality Foreign Bonds.
Municipal bonds: Municipal Bonds will remain volatile over the first half
of 2009, but we expect improvement later in the year. The continued
absence of non-traditional buyers, potential for additional forced selling,
and above average new issuance will likely keep Municipal Bonds cheap
relative to Treasuries. Supply needs will likely remain elevated as states
and municipalities issue debt to help finance budget shortfalls. The supply/
demand imbalance will likely persist, despite the longer-term possibility of
higher tax rates. This implies that high quality municipal yields are likely to
remain above Treasury yields well into 2009. Recall that current marginal tax
rates are set to expire at the end of 2010, when the top rate will revert back
to 39.6% from its current 35%.
Alternative Investments ^
In our 2009 base case, we expect a more challenging environment for
alternative asset classes on a relative return basis as the equity and credit
markets improve. However, those same factors will likely put alternatives in a
better position to provide help with the market’s volatility.
The market dislocation of 2008 provided alternative investments with the
opportunity to move into the mainstream and prove their worth as long-term
participants in the portfolios of retail clients. Conservative use of alternatives
resulted in more stable performance, even in the face of challenges within
many alternative asset classes. Most alternative strategies—though not
all—managed to outperform the equity markets. From a portfolio perspective,
strategies that can take advantage of volatility, such as Managed Futures,
Global Macro, Covered Calls, Market Neutral and to a lesser extent, Absolute
Return and Long/Short, rose to the challenge and once again proved to be
useful diversifiers.
Some of the prominent themes we expect to see playing out in our base case:
„ Equity fundamentals will regain importance in stock selection. This return
to fundamentals should be positive for Long/Short, Market Neutral, and
other alternative strategies that focus on valuations and enterprise value.
„ Low Treasury yields will create an opportunity for conservative use of
Market Neutral and Absolute Return funds.
„ The investment case for Distressed Debt will continue to grow as the
economy faces continued challenges.
„ The volatility that will continue into 2009 should moderate as we move
through the year. Declining volatility will gradually lessen the advantage of
Covered Call strategies.

„ Managed Futures may see more moderate performance as some of the
significant trends of 2008 plateau.
„ A delevered market will create opportunities both in alternative and long-
only strategies.
2. Bear Case
Key premise: The financial panic that began in September
2008 lingers well into 2010, and financial markets do not
normalize at all over the course of 2009.
Economy
Economic Backdrop Assumptions:
„ Recession status: The recession in the United States is worse than the
1981-82 experience and lasts much longer than 16 months. Real GDP
growth declines sharply (by 5% or more) in both the fourth quarter of
2008 and the first quarter of 2009, ahead of a choppy, but still negative
last three quarters of 2009 where real GDP growth is likely to average
-1.0%. The persistent lack of liquidity and credit availability causes
businesses and consumers to spend even less, and international
economies are even worse off than the U.S. economy due to lack of
global lending. Our bear case assumes that the economy experiences
the worst recession since the 1930s and that the policy response, both
fiscal and monetary, will be unlike anything we have seen since the
1930s. The recession that began in 2007 will be long in terms of time
and vast in terms of impact.
„ Inflation: Deflation intensifies and persists throughout 2009, and severe
stagflation—high and rising inflation combined with near zero or negative
economic growth—is likely in 2010.
„ Unemployment: The unemployment rate moves well past 10%. (The
unemployment rate hit 10.8% at end of 1981-82 recession.)
„ Home prices: The U.S. housing markets continue to deteriorate, with rising
delinquencies and foreclosures, and another sizeable (10% or more) drop
in U.S. home prices over the course of the year.
„ Oil: Oil prices sink to their long-term average price per barrel of between
$18 and $22.
„ Dollar: International economies approach full-out depression as the
United States pulls back swap lines with other foreign central banks.
The US dollar rallies more than 10% in a flight-to-safety from crumbling
overseas economies.
Federal Reserve Actions:
„ Target interest rate: The Fed maintains near zero effective fed funds rate.
„ Balance sheet: The Fed continues to buy Mortgage-Backed Securities
and starts to buy U.S. Treasuries and Corporate Bonds to recapitalize
most financial institutions. The Fed expands its balance sheet rapidly and
intensifies reflation efforts.
„ Money supply: The Fed’s reflation policy sharply increases the money
supply in 2009.
B E AR C AS E
[Continued from page 12]
The yield advantages of Corporate Bonds,
Agency Bonds, Preferred Stocks, and
Mortgage-Backed Securities relative to
Treasuries are at or beyond the biggest
ever witnessed in the bond market. The
added income benefit should provide
a buffer to help weather the storm of
volatile markets. In a bond world awash
with cheap securities, we believe higher
quality bonds will benefit first as investors
reach for these first in taking baby steps
out on the risk spectrum. Although this
process may take some time, liquidity will
likely improve for high quality assets first.
Municipal Bonds were a victim of the credit
crunch, but yields remain above Treasuries
across the maturity spectrum. Investors
in slightly lower tax brackets that may not
have traditionally considered Municipal
Bonds may wish to do so given the historic
dislocation and still high credit quality of
the asset class.
The challenges that some alternatives
faced in 2008 may lead to some
remarkable opportunities in 2009 and
beyond. Throughout 2009, however,
there is likely to be a shift from mutual
fund strategies that help with volatility,
like Covered Calls and Global Macro, to
investments that search for value in credit
and stocks. Attractive valuations and an
increase in default rates, for instance,
appear to be providing opportunities to
build positions in Distressed Securities.
Long/Short and Absolute Returns
strategies should also provide solid
returns if we see credit markets normalize
and stocks rebound.
^ Keep in mind such strategies are subject to increased risk due to
the use of derivatives and futures and may not be suitable for all
investors and should be considered as an investment for the risk
capital portion of the investor’s portfolio. The strategies employed
in the management of alternative investments may accelerate the
velocity of potential losses.
13
 B E AR C AS E

Government Actions:
Spot Oil Price: West Texas Intermediate
In our bear case for the economy, oil prices could return to „ Stimulus package: The first stimulus package enacted in early 2009
their long-term average of $18 to $22 per barrel. (2% to 4% of GDP) does not prove to be enough. A second plan has
150
to be enacted—roughly the same size as the first, but with direct cash
payments to taxpayers.
125 Long Term Average is Between
$18 and $22 per Barrel
„ Budget deficit: The U.S. budget deficit exceeds $1 trillion, or more than
100
7.0% of GDP.
75 „ Other measures: The U.S. government embarks on a more dramatic
50 and direct program of housing relief, and begins to buy homes from
homeowners, banks, and other mortgage holders. The U.S. Congress
25
and foreign governments press for more protectionist measures, which
0 further slow world trade.
75 80 85 90 95 00 05
Source: Wall Street Journal / Haver Analytics 12/03/08
Equity Markets
In our bear market scenario, at year-end 2009, we anticipate the S&P 500
index will be at around 560. This would be driven by an 8 price-to-earnings
ratio (P/E) on the next 12-months expected earnings per share (EPS) of
about $58 in 2010 and a dividend yield of 3% to 4%. For context, these
levels would result in about another 35% decline after stocks have already
posted a 52% peak-to-trough decline (through November 2008). More
details follow about how we reached these values for the three component
parts of S&P 500 total return: EPS, P/E, and dividend yield.
Earnings per share (EPS): The ongoing financial crisis causes S&P 500 EPS
to plummet another 20% to about $58 in EPS for 2009. The earnings
would be made up of the earnings streams of only the most defensive
S&P 500 companies. The Healthcare, Consumer Staples, Utilities, and
Telecommunication sectors would likely contribute half of the total, while
the defensive positions of the other six, more cyclical, sectors of the S&P
500 would make up the rest. Each of the Energy, Industrials, Information
Technology, Consumer Discretionary, Financials, and Materials sectors
would likely contribute less than half of the dollar amount Wall Street
analysts expect in 2009. This outcome would bring the earnings for these
cyclical sectors down more than 50% from peak levels. The result would
be the worst earnings decline in the post-WWII period. Some improvement
in the macro economic backdrop, earnings growth, and confidence by the
second half of 2010 may result in the return of some cyclical sources of
earnings, and then EPS may lift to about $70, below the 2008 level and
more than 20% below the mid-2007 peak.
Price-to-earnings ratio (P/E): If confidence remains weak as the recession
deepens and lingers while credit markets remain seized, and aggressive
deleveraging is ongoing throughout the year, an 8 forward P/E multiple
appears reasonable.
Dividend yield: The dividend yield would rise as stock prices fall proportionately
more than dividends are cut. The yield would likely average between 4% and
5% during 2009.
International equities: Though stocks around the world would suffer major
additional declines in the bear case, the flight-to-safety havens like U.S.
Treasury debt would push up the value of the dollar, which would boost
the relative performance of U.S. over international stocks. In addition, the
generally more cyclical earnings streams of non-U.S. companies would likely
result in even greater earnings declines in Europe and Asia than in the United

14
 B E AR C AS E

States. Valuations outside the United States may fall under more pressure as
What should investors do if they
well as protectionism stemming from the crisis increases. A return to more
believe the bear case will unfold
fiscal spending in the Eurozone could lead to a breakdown of the European
in 2009?
Union and Asia, as China’s GDP nearly turns negative after a decade of
growth of 10% or more. In the bear case, investors may want
to adopt a defensive posture by
Fixed Income Markets underweighting the stock market and
favoring the safest investments, such as
In the bear case for bonds, liquidity does not improve in 2009 and financial
cash equivalents. The outlook for deflation
institutions limit participation in financial markets. We expect bond
in this bearish scenario means that gold, a
performance, as measured by the Barclays Aggregate Bond Index, to range
traditional safe haven, may also suffer.
from low- to mid-single digits for 2009. Illiquidity plagues the spread sectors,
and yield spreads to Treasuries creep wider, establishing new record wide With substantial additional downside
levels. Thus, investors would flock to Treasuries, causing the prices of non- likely for stocks in this scenario, focusing
Treasuries (Corporate Bonds, Agency Bonds, Mortgage-Backed Securities stock market exposure on Large
(MBS), High-Yield Bonds, Foreign Bonds, Bank Loans, and Municipal Bonds) Cap Growth defensive sectors like
to decline further. Within credit markets, lower rated issues and longer- Consumer Staples and Healthcare and
term issues underperform as investors seek top quality issuers and keep underweighting cyclical stocks in the
maturities short. Illiquid markets also exacerbate market impacts resulting Financials, Consumer Discretionary, and
from further deleveraging. Information Technology sectors is likely
to result in the best relative performance.
Treasuries: We expect Treasury yields to drop further into record low territory
Alternative strategies that emphasize
as the flight-to-safety continues and approach levels of Japanese government
short positions may also provide a hedge
bonds; the 5-year Treasury yield drops below 1.0%, and the 10-year note yield
against further stock market declines.
drops below 2.0%. Real yields drop further, making Treasuries even more
expensive as they outperform spread sectors by a notable margin. In the fixed income market, investors
should overweight long maturity
Corporate Bonds, Agency Bonds, and MBS: We believe that yield spreads
Treasuries. The safe haven of the explicit
on these non-Treasury sectors will widen, failing to benefit from price
government backing of these securities
appreciation associated with Treasury yields’ declining 0.25 to 0.75
may likely result in lower yields and
percentage points. Treasury price gains are offset by price weakness in
rising prices, which is typically more
Corporate Bonds, Agency Bonds, and Mortgage-Backed Securities, although
pronounced for longer maturities.
we expect to a lesser degree than in 2008. Overall, these sectors generally
Investors should underweight the credit
continue to suffer, as investors are unwilling to take on risk.
markets—especially High-Yield Bonds,
High-Yield Bonds: High-Yield Bond spreads widen to the mid-to-high 20% investment grade Corporate Bonds, and
range as the market braces for a surge in defaults. The severity and depth Preferred Stocks.
of the recession pushes the default rate several percentage points past the
If the bear market case ensues,
1991 record of 13%.
alternative asset classes may be one of
Foreign Bonds: Along with U.S. Treasuries, high grade Foreign Bond yields the few areas of the market in which to
move lower, spurred not only by the flight to quality but also by more find refuge. Alternative asset classes can
aggressive interest rate cuts. Therefore, the prices on these government serve as substitutes for equity and fixed
securities continue to climb. Foreign central bank lending rates, except income allocations, delivering strong
Japan’s, approach those of the target Fed Funds rate. Hedged Foreign relative returns in the markets. To help
Bonds outperform unhedged ones as the currency effect of a stronger US with volatility prevailing in both markets,
dollar, which benefits from flight-to-safety flows, is likely to more than offset the areas of opportunity are: Long/Short,
potential price gains from lower interest rates. In fact, we would expect a Covered Calls, Managed Futures, Global
greater performance differential between hedged and unhedged Foreign Macro, Absolute Return, and Market
Bonds under this case than under the base case scenario. Neutral funds. Distressed Debt funds will
also continue to find attractive values;
Municipal Bonds: Municipal Bonds underperform Treasuries as investors price
however, in a continued bear market,
in decreasing credit quality at the state and local level. Under this scenario
positive returns from these strategies
it is likely Municipal yields could increase even as Treasury yields decline,
will be delayed.
repeating a situation that has happened on a few occasions over the past
15 months. The supply/demand imbalance worsens and also contributes to
Municipal Bond underperformance.

15

Counterintuitive: Beware
Being in Cash When this
Bubble Bursts
A 50% gain in the S&P 500 could be the
outcome of the bursting of a bubble in
cash equivalents. Because investments
in money market securities are unlikely
to produce large losses on the downside
of the bubble, the growth in demand for
money market securities is not a typical
financial bubble. However, a comparison
to the dot-com bubble can help illustrate
the opportunity cost when the cash
equivalents ‘bubble’ bursts. During the
Tech bubble, the market value of the
Tech sector grew to about 35% of the
S&P 500 index before returning to the
mid-teens weighting it had averaged over
the long term. Money market mutual
fund assets are now nearly as high as the
market value of the S&P 500 Tech sector
at its peak, about $4 trillion. This amount
of cash is equivalent to nearly half the
value of the entire S&P 500. Prior to the
enormous accumulation of cash in money
market mutual funds over the past year,
money market mutual fund assets were
equivalent to about 20% of the value
of the S&P 500. If this demand bubble
bursts, the classic pattern suggests a
return to the 20% level, and that would
result in an opportunity cost for holding
cash equivalents as trillions flow back into
the capital markets and the stock market
experiences powerful gains.
Another Sort of Bubble Has Formed
Tech Sector and Money Market Assets as a Percent of
S&P 500 Market Cap
Tech Sector Weighting in S&P 500 from Feb 1996 - Feb 2004
Money Market Assets as Percent of S&P 500 Market Cap Since Sep 2004
50%
45%
40%
35%
30%
25%
20%
15%
10%
5%
0%
Sep-2004 Sep-2006 Sep-2008
Source: Haver Analytics / LPL Financial Research
16
B UL L C AS E
Alternative Investments
Regardless of market scenario—base, bear, or bull—some alternative
investments will present opportunities. In the bear case, those that help
with volatility and distress in the markets are poised to perform well on
an absolute and relative basis. Managed Futures and Global Macro could
potentially deliver double-digit returns as economic and market trends
continue. Covered Calls and Long/Short equity funds would likely see smaller
declines than the broad equity market, potentially in a range of 12% to 22%.
Investing in alternative investments may not be suitable for all investors and should be considered as an
investment for the risk capital portion of the investor’s portfolio. The strategies employed in the management of
alternative investments may accelerate the velocity of potential losses.
Bull Case
Key premise: The financial panic that began in
September 2008 subsides by year-end 2008 or early
2009, allowing a normalization of financial markets
shortly thereafter.
Economy
Economic Backdrop Assumptions:
„ Recession status: The U.S. economy experiences one last big down
quarter in the fourth quarter of 2008—with real GDP contracting by
more than 5%—but then stabilizes in the first half of 2009 before rising
at an annualized rate of between 2.5% and 3.5% in the second half
of 2009. The recovery is spurred by the cumulative impact of Fed and
Treasury policy actions taken to date. These actions, along with more
“toxic asset” lift outs—similar to the Citigroup rescue plan that was put
into place in mid-November 2008—for other large financial institutions
finally gain traction and allow credit to flow to all sectors of the economy.
Healing in markets that have been directly impacted by government
intervention spreads to markets where there has not been direct
intervention.
„ Inflation: Headline inflation moves higher with oil, and the lagged effect
of the expansion of the money supply the Fed did in late 2008 into early
2009 leads to a sharp uptick in core inflation in 2010 and beyond.
„ Unemployment: The unemployment rate peaks out between 7% and 7.5%
during 2009.
„ Home prices: Aided by a massive effort by the FDIC and other
government entities to rework millions of mortgages, the housing market
bottoms in the fourth quarter of 2008. Home prices stop falling and
even begin to rise, and foreclosures dry up. The risk of defaults in earlier
(vintage 2004 and 2005) tranches of mortgages fades.
„ Oil: Oil prices average $70 and end the year at $80, as the global
economy recovers.
„ Dollar: Massive stimulus overseas dampens impact to non-U.S.
economies, allowing U.S. export growth to decelerate, but not decline
outright as it has in prior severe recessions. The US dollar is flat to down
between 5% and 10%, as the “flight to quality” bid ebbs.
Sep-2010
 B UL L C AS E

Federal Reserve Actions:

The United States has Experienced Five Periods
„ Target interest rate: The fed funds rate is slowly moved back to “neutral” of Deflation Since 1925
by year-end 2009 (about 3%–4%) in an effort to prevent inflation from Year-Over-Year Change in Consumer Price Index
flaring up in 2010 and beyond. 25%

„ Balance sheet: Seeing its prior policy actions take hold, the Fed lessens its rate 20%

and amount of capital injections. The Fed balance sheet begins contracting. 15%

10%
„ Money supply: Though there is some increase in the money supply in late
5%
2009, it is minimal.
0%
Government Actions:
-5%
„ Stimulus package: The first fiscal package (infrastructure based and roughly -10%

2% to 4% of GDP) is enough to boost the economy. There is no need for -15%

1925

1933

1941

1949

1957

1965

1973

1981

1989

1997

2005
a second stimulus package, but Congress passes one, as they have in the
past. A middle class tax cut—likely coupled with tax increases for taxpayers Source: Bloomberg / LPL Financial Research
in the upper brackets—is passed as part of the stimulus program.
„ Budget deficit: The U.S. budget deficit rises to more than $700 billion, or
It is important to keep in mind that
about 5% of GDP.
not all periods of deflation have had
„ Other measures: The unneeded second stimulus package raises the odds of negative consequences. Deflation, or
more aggressive Fed rate hikes (and higher inflation) in 2010 and beyond. a negative rate of inflation, often brings
Equity Markets to mind the painful period of the Great
Depression in the U.S. However, a mild
At year-end 2009, our bull case puts the S&P 500 index at about 1365, driven
by a 13 price-to-earnings ratio (P/E) on the next 12-months expected earnings
case of deflation — following a period
per share (EPS) of about $105 in 2010 and a dividend yield of 2% to 3%. If of above average inflation — has been
the bull case were to unfold the biggest risk to the economy in 2009 and welcomed by market participants.
beyond would be an uptick in inflation. The upward movement would begin The United States experienced mild
to appear late in the year and continue into 2010. If the preventive measures bouts of deflation in the 1920s and
taken by the Fed to quell inflation do not succeed then it is likely that a Fed 1950s. During these periods, stocks
induced “double dip” recession occurs in 2010 and 2011. rose at an above average pace. If mild
Earnings per share: The rapid turnaround in the credit markets and economy deflation is as bullish for equities as
lead to a typical post-recession earnings rebound for S&P 500 companies it was on average in the 1920s and
of between 20% and 25% year-over-year growth for the eight quarters 1950s gains of about 50% could be
beginning in the second quarter of 2009, which would result in 2009 EPS in forthcoming in 2009.
line with the Wall Street analyst consensus of about $87, rising to a new high
of about $105 in 2010.
Price-to-earnings ratio (P/E): If confidence returns swiftly in 2009, valuations MAGNITUDE OF DEFLATION
may rise from the current 9 to 13. Over the 30 years prior to 2008, when AND MARKET PERFORMANCES
the yield on the 10-year Treasury note was below 7.5%, the lowest price-to- Performance in the U.S. measured by Dow Jones
earnings ratio on the Thomson Financial-tracked analyst consensus earnings Industrial Average and in Japan measured by the
expectations over the next 12 months for the companies in the S&P 500 Nikkei 225 Stock Average*
index was 13.
Mild Deflation Periods Extreme Deflation Periods
Dividend yield: The dividend yield would fall as stock prices rise. The yield Stock Market Stock Market
would likely average between 2% and 3% during 2009. Period Performance Period Performance
+86% Jul 1930 - -62%
International equities: If the global economy picks up in tandem with the July 1926 - May 1929
Oct 1933
U.S. economy, the relatively more value-oriented international markets may +24% Sep 1999 - -5%*
outperform U.S. stocks. International stocks tend to outperform as global Mar 1938-Jan 1940
Sep 2007
growth reaccelerates. When global leading indicators are rising, the MSCI +29%
May 1949-Jun 1950
EAFE Index has almost always outperformed the S&P 500. In addition,
the dollar may reverse the gains of 2008 as capital seeks higher returns Sep 1954-Aug 1955 +47%
Source: Bloomberg / LPL Financial Research

17

What should investors do if they
believe the bull case will unfold
in 2009?
In the bull case, investors would want to
overweight stocks and underweight high-
quality bonds. While volatility may remain
high, trimming alternatives exposure and
focusing on long-only investments is likely
to deliver the best leverage to sharply and
steadily rising markets.
In the stock market, investors would
want to overweight the most cyclical
stocks in the Financials and Consumer
Discretionary sectors along with the high
beta Information Technology sector, while
underweighting the defensive Utilities and
Consumer Staples sectors. The Financials
sector will benefit from the improvement
in the credit markets, and the Consumer
Discretionary and Information Technology
sectors will benefit the most from
accelerating economic and earnings
growth. Additionally, the domestic equity
asset class that tends to perform the
best as the credit markets and economy
rebound from recession is Small Cap
Value. The rebound in the credit markets
and the pace of economic growth would
result in a powerful rebound in EPS
for Small Cap Value stocks. Small Cap
stocks have always outperformed Large
Cap stocks during the first third of the
business cycle as the markets rebound
from recession.
In the fixed income markets, investors
should underweight Treasuries and
overweight High Yield Bonds, investment
grade Corporate Bonds and Preferred
Stocks as the credit markets quickly
improve and the financial crisis fades
while the year gets underway.
Investors should reduce the overall
portfolio allocation to alternative asset
classes. Investors may also consider
opportunities presented by Absolute
Return and Market Neutral funds as
substitutes for fixed income securities in
the face of rising yields.
18
B UL L C AS E
rather than a safe haven. As the dollar falls, the dollar return on international
investments rises.
Fixed Income Markets
In the bull case, bond market liquidity improves during the first quarter of
2009. We would expect strong Corporate Bond performance in the high-
single digits to low double-digits to push overall bond market performance
up to a range of high-single digits.
Treasuries: Treasury yields bottom during the first quarter of 2009. Throughout
the remainder of the year Treasury yields gradually move higher because of
heavy Treasury issuance, stronger economic growth and possible Fed rate
hikes late in the year. Under this scenario we would expect Treasury yields to
rise by 0.50 to 1.50 percentage points, lowering the price of these securities.
(Real yields increase as Treasury valuations decrease.)
Corporate Bonds, Agency Bonds, and MBS: Credit spreads begin to slowly and
steadily tighten early in 2009, and all spread sectors outperform Treasuries.
Within spread sectors, lower rated spread sectors such as High Yield and
Bank Loans outperform. Corporate Bond prices would rise, but Agency
Bonds and Mortgage-Backed Securities prices would be mixed, depending
on the degree of the interest rate change.
High-Yield Bonds: The improved liquidity environment and stronger economic
growth lead to substantial spread tightening in the High Yield sector. Default
rates continue to increase but rise less than expected to 7% to 9% and do
not impede spread tightening. In an environment where the economy shows
meaningful improvement, spreads could tighten by roughly half, which would
still only take the market to just below 2002 peak High Yield spread levels.
Foreign Bonds: Overseas Foreign Bond yields are stable to slightly higher.
A move higher in bond yields is greater in Treasuries as the United States
emerges first out of the global recession and foreign central banks likely
continue rate cuts and then remain on hold longer than the Fed. Friendlier
foreign central banks help keep the rise in Foreign Bond yields more
restrained compared to the rise in U.S. Treasury yields. Unhedged Foreign
Bonds outperform hedged Foreign Bonds due to the currency effect as the
dollar weakens on a reversal of flight-to-safety flows.
Municipal Bonds: Municipal Bond yields stabilize and then improve versus
Treasuries. Municipal Bonds would outperform Treasuries for the entire
year. Non-traditional buyers would return in limited capacity by mid-year and
help resolve the supply/demand imbalance sooner than anticipated. Forced
liquidations do not materialize and new issuance is less than expected as
state revenues hold up better than expected. Municipal Bonds receive an
added push late in 2009 on the prospect of the Bush tax cuts expiring or
higher tax rates as the economy improves.
Alternative Investments
With both equity and credit markets up significantly, most alternative
strategies would trail on a relative basis. Managed Futures, Covered Calls
and other “volatility thriving” mutual fund strategies would likely provide
returns in the low- to mid-single digits but with significant volatility along
the way. Distressed Debt and long-biased Long/Short would provide returns
more in-line with equities for the year.
Investing in alternative investments may not be suitable for all investors and should be considered as an
investment for the risk capital portion of the investor’s portfolio. The strategies employed in the management of
alternative investments may accelerate the velocity of potential losses.
 GRE AT DE P R E S S I ON I I

Chapter 2
Great Depression II?
— Why it is Highly Unlikely
The Great Depression came about because of
serious economic and monetary policy errors that
compounded what was already a serious recession.
Actually, according to the National Bureau of
Economic Research (NBER), the official date setter
of U.S. recessions, there were two major back-
to-back recessions in the 1930s, with a significant
recovery in the middle. The economy and regulatory
environment of the 1930s are a far cry from today’s,
but can a great depression occur again? We believe
it cannot. But it is important to understand why the
1930s great depression unfolded as it did and the
lessons that the experience offers for today.

1930s Recessions
There are several key elements of recessions. As shown in the four charts
1 Industrial Production Index during the
in the margins (recession areas are shaded), there was a recovery that
1930 Recessions
started in 1933 but was aborted in 1937. During the recovery, U.S. industrial
In recessions, the industrial production index drops and in
production rose 121% before nose diving a second time in 1937 and 1938.
recoveries, it rises.
Additionally, the unemployment rate followed a similar up, down, and then
back up pattern. 12

The main problem throughout the Great Depression was, in our opinion,
10
highly ineffective monetary policy on the part of the Federal Reserve. As
the first recession was underway in mid-1929, the Fed did nothing; actually
8
worse than nothing, it allowed the money supply to contract and did nothing
to support the banking system. The Fed is supposed to be the “lender of
last resort”, but back then it did not accept that role. Its policy was to lend 6

reserves to banks only if those loans were collateralized by investment grade

corporate debt. It would not even accept government securities as collateral. 4
28 29 30 31 32 33 34 35 36 37 38 39 40
As the recession deepened, more and more corporate debt on banks’ Source: Federal Reserve Board / Haver Analytics 12/01/08
balance sheets dropped below investment grade. When depositors started
withdrawing money from the banks, the Fed refused to give banks enough
borrowed reserves to meet the deposit runs, and a wave of bank failures

19
 GRE AT DE P R E S S I ON I I

ensued. This first wave made the 1929-32 recession very deep. Then, the
2 Unemployment Rate during the 1930 Recessions recovery started underway. However, between 1936 and 1937 the Fed
In recessions, the unemployment rate rises and in doubled the bank reserve requirements. The demand by the Fed for higher
recoveries, it drops. reserves triggered a second wave of bank failures, and another deep
30 recession took hold. Industrial production plunged again, real GDP fell again,
25
and the GDP price index, which had already fallen about 25% in the first
recession, fell again in the second.
20
So, although there were a number of serious blunders in fiscal, regulatory,
Percent

15
and trade policies, we view the main cause of the depression to be very
10 counterproductive monetary policy by the Fed. Today, we view monetary
policy as strongly headed in the exact opposite direction—the right
5
direction. Over the last three months, the Fed has expanded bank
0 reserves from their normal level of about $45 billion to more than $650
29 30 31 32 33 34 35 36 37 38 39 40 billion, accepting just about any assets the banks have as collateral for
Source: Federal Reserve Board / Haver Analytics 12/01/08 loans. The Fed is also in the process of generating a major expansion in the
money supply, with the monetary base nearly doubling during the last three
months. M1 has increased 9% during the last three months. Given these
actions, coupled with much improved fiscal, regulatory, and trade policies,
we consider the probability of a return to the “Great Depression of the
1930s” to be highly unlikely.
3 Real GDP during the 1930 Recessions Not Repeating the 1930s
Generally one of the requirements for a recession is
negative growth in real GDP.
For the United States to enter into a depression like the one in the 1930s,
huge policy mistakes would have to be made, and made quickly. We do not
22.5
think these mistakes will be made, but want to outline what they might be
15.0
and how they would impact the economy and markets.
Policy mistakes would include:
Percent Change

7.5
„ The Fed reversing course and increasing rates over the course of 2009.
0.0
„ The Fed raising bank reserve requirements.
-7.5
„ The Fed abruptly discontinuing the reflation program that it has
15.0 already begun.
29 30 31 32 33 34 35 36 37 38 39 40
Source: Bureau of Economic Analysis / Haver Analytics 12/02/08
„ A wave of global protectionism.
„ The elimination of the TARP and related housing and bank
rescue measures.
Consequences of those policy mistakes for the economy and markets
would include:
„ Real GDP falls by an annualized 7% per quarter for all of 2009.
4 GDP Price Index During the 1930 Recessions
„ The unemployment rate soars past 25%.
Generally during recessions the price of products fall.
„ Deflation grips all asset prices.
12.00
„ Oil approaches $5 a barrel.
11.25
„ Massive corporate and personal defaults—greater than 20%-25%.
10.50
„ Social unrest increases in the United States, along with a continued
9.75
increase in social disorder overseas.
„ The US dollar rises due to a flight to quality.
9.00
„ The Eurozone breaks apart.
8.25
28 29 30 31 32 33 34 35 36 37 38 39 40
„ Gold soars.
Source: Bureau of Economic Analysis / Haver Analytics 12/01/08

20
 GRE AT DE P R E S S I ON I I

Equity markets: Under another great depression, we believe the S&P 500
index would fall to a level of 360, driven by an 8 price-to-earnings ratio
(P/E) on the next 12-months expected earnings per share (EPS) of about
$45 in 2010 and a dividend yield of 5% to 7%. For context, this would be
an additional 60% decline from current levels and would erase 12 years
of earnings growth. The index would likely be mired there for the next few
years. If this scenario of “completely eroded confidence with no end in
sight” unfolds, investors would focus on only the most defensive of earnings
streams, and relative performance among equity asset classes would be
immaterial to the magnitude of the losses across all asset classes.
Fixed income markets: We would expect T-bill yields to turn negative and
expect the 10-year Treasury Bill to trade below 1% and move close to 0%.
Investors would be seeking any and every safe haven—and government-
issued and guaranteed debt would be the place to go. With yields at 0%
or negative, investors would be paying the government to hold their money.
However, investors acknowledge that knowing their assets are safe is
worth the price.

Definitions of M1, M2, and M3

M1. A money supply category which
approximates cash used by consumers
and companies; consisting primarily of
currency in public circulation, credit union
share account balances, NOW account
balances, automatic transfer account
balances, demand deposits, and travelers
checks.

M2. A money supply category consisting

of all money in the M1 category plus
“quasi-cash” balances such as Eurodollar
deposits, savings and other small
deposits, and private holdings in money
market mutual funds.

M3. A money supply category

consisting of all money in the M1 and
M2 categories, plus large deposits,
institutional shares in money market
mutual funds, and term repurchase
agreements.

21
 GRE AT DE P R E S S I ON I I

Japan’s Great Depression

While we all agree that we are in uncharted territory and that there are plenty of risks and uncertainty, we
do not see the U.S. economy following a path similar to Japan’s sustained deflation that began in the late
1990s and continues through today.

Cash returns at 1% does not become a “store of value” if the money supply expands sufficiently to
generate a medium to high inflation rate. We think this fact will solve the “liquidity trap”, help solve the
problem of further home price declines, and thereby help stop further bank mortgage loan deterioration.
We believe Federal Reserve Chairman Bernanke understands this situation and that we will, in part, inflate
our way out of the current financial crisis.

Japan The United States

Japan made a number of serious mistakes leading to years While this country does share some of the Japanese issues,
of sustained deflation. and there is some risk of creating “zombie” banks, it is
not nearly as universal as it was in Japan. There are still a
No forced failures: They did not force bank failures or
lot of good banks with positive net worth and motivated
mergers and left many banks standing as “zombies,” with
management teams in the United States that will likely be
negative net worth and unmotivated management that did
making loans at rates well above 1%. We do not think many
not have the capital to expand lending. Consequently, net
U.S. banks will be content to sit on nearly $1 trillion in excess
private sector lending in Japan has been flat over the last
bank reserves collecting 1% as a viable long-term strategy.
15 years.
We do think the Fed will allow a sizable expansion of the
No money supply growth: The Bank of Japan (BoJ) did money supply (M1 has already accelerated to a 10% growth
expand their balance sheet, but did not permit a major rate) and this expansion will create a rise in inflation at the
expansion of the money supply. In Japan, M1, M2 and M3 end of 2009 and into 2010. Until then the plunge in oil and
have experienced very low or no growth for many years. commodity prices will drive a sharp decline in the total CPI
Argentina, Mexico, and many other nations have effectively and other inflation rates. In our opinion, the previous five
expanded their money supply and created higher inflation. years of rises in housing, oil, and commodity prices were
bubbles, due to a nearly complete disregard for risk and
No yen devaluation: Japan did not foster a devaluation of the
regulatory failures, not due to an inflationary U.S. monetary
yen, which had appreciated enormously (about 200%) since
policy. Therefore, the current decline in these prices does not
the 1970s. Instead, they chose to get back to purchasing
signal a deflationary U.S. monetary policy.
power parity the hard way, through continuous deflation.
Unlike the Federal Reserve in the 1930s, Japan’s central bank
did stop a general bank collapse. However, the BoJ didn’t
avoid making all of the Fed’s 1930s mistakes as it allowed
a halt in bank lending and did foster deflation. In Japan, the
GDP price index has been falling continuously for more than
a decade. Japan is the only major industrial country that
can print currency without a AAA government bond rating.
We believe the rating agencies worry that the BoJ may not
effectively manage or produce yen to pay the bond coupons.
Japan also has been plagued by extremely poor fiscal policy,
regulatory oversight, corporate governance, actuarial snafus,
among other issues that make recovery very difficult. The
complete control of policy by the Liberal Democratic Party
(LDP) has not been good for the economy. It is a testament
to the commitment of Japanese workers and management
to have carried on under such a heavy burden, considering
the level of industrial production in Japan is about the same
as it was 15 years ago—compared to a 50% increase in U.S.
industrial production over the same time period.

22
 IMPACT OF WA S HI N GT ON

Chapter 3
Impact of Change in Washington
The President has a lot of impact on foreign policy
and trade, and selects the heads of the regulatory
agencies. The Senate sets the pace on taxes, laws
affecting business, and other issues of interest to
investors. What impacts the new administration
and Senate and House majorities will have on the
economic and market revitalization are not clear.
With that caveat, the following descriptions illustrate
what the investment environment for various sectors
might look like in 2009, assuming our base case
scenario for the economy and markets.

Consumer Discretionary
„ Potential copyright legislation under a Democrat-controlled Congress is
likely to favor entertainment content providers.
„ A bailout package is likely for the big three automakers that will postpone
cuts to the workforce. However, the auto industry is unlikely to have it
easy in 2009.
„ A Democrat-appointed head of the EPA, with authority upheld by a
recent Supreme Court ruling, will push automakers for higher fuel
efficiency standards. New technology comes at a higher cost than
consumers have been willing to embrace, which may negatively impact
already low profit margins in the industry.
Consumer Staples
„ Pro-union measures adopted by Congress may weigh on profitability and
limit expansion by companies in this sector.
„ Expanding ethanol use to 85% ethanol/gas blends via tax incentives or
mandates benefits ethanol producers.
„ Potential extended FDA restrictions on advertising for tobacco products
could benefit producers by saving them billions while only slowing
domestic consumption marginally as international growth continues. An
increase in the tobacco tax could be a slight negative.
23
 IMPACT OF WAS HI N GT ON

Energy
„ Headline risk rises for energy companies. However, we doubt oil and gas
firms will be subject to any especially negative actions, such as a windfall
profits tax.
„ Increased royalty payments for the use of public land and offshore sites
may be an incremental negative for major integrated oil companies.
„ A climate change program for greenhouse gas emissions, which raises the
cost of using coal, may be an incremental positive for natural gas producers.
„ The delay in adding new capacity for other utilities, combined with
the additional time frame to actually build new power generation plants,
will likely lead to increasing natural gas demand to meet rising demand
for power.
Financials
„ New, more sweeping regulation is likely for this sector. We may see
increased scrutiny and liability for predatory lending.
„ Democrats may enact legislation allowing bankruptcy courts to lower
mortgage loans, change interest rates, and prohibit prepayment
penalties—all negatives for lenders.
„ Credit rating agencies may be negatively affected by potential legislation
mandating changes in their business models or banning consulting.
„ The potential cap on the tax exemption for annuities above $1 million
may be a negative for insurers.
„ The potential expansion of retirement savings plans may benefit asset
management companies.
„ Climate change initiatives may expand new trading markets such as
carbon emissions and weather futures. Venture capital and private equity
investment in clean energy firms has surged, and is likely to continue to
be a boost to advisory and underwriting fees.
Healthcare
„ Healthcare legislation is more likely a 2010 event, as 2009 legislation
focuses on the more pressing fiscal stimulus and tax issues.
„ Potential legislation on universal healthcare would be a negative for the
managed care industry, making private health insurance less profitable
and shifting market share to government plans. More importantly,
managed care could be hurt by changes to Medicare Advantage
reimbursements.
„ The threat to government control of pricing for pharmaceuticals has
been priced in for years—with U.S. drug stocks trading at valuations
comparable to counterparts in Europe, where healthcare is socialized.
„ Under comprehensive healthcare reform, many healthcare industries
would likely benefit. For example, drug companies could experience
increased demand, as they did after Medicare Part D was introduced.
Other industries including providers (hospitals, nursing homes),
diagnostic labs, and even generic drug makers may benefit from
Democrats’ healthcare proposals expanding healthcare coverage,
emphasizing preventative care, and focusing on generics.

24
 IMPACT OF WA S HI N GT ON

Industrials
„ Congress may demand through regulation, taxation, and incentives, that
environmentally-friendly technologies like carbon capture, solar, and
wind become a much larger portion of U.S. power generation—creating
opportunities for companies that provide alternative power and delivery
of alternative fuels.
„ Companies tied to large defense programs could come under additional
pressure, although companies tied to port security, chemical plant
security, homeland security spending, and regulation in general should
benefit, as Democrats may increase funding in these areas.
Information Technology
„ Potential legislation supporting healthcare technology investment and
a potential network tied to Medicare reimbursement could be positives
for this sector.
„ Climate change initiatives may boost companies producing solar and
energy efficiency products or the semiconductor equipment used in
those products.
Materials
„ A fiscal stimulus package focused on highway infrastructure spending
may benefit the suppliers of paving and other materials as well as the
construction companies.
„ Extraction industries may face tougher environmental rules
and enforcement.
„ The potential for climate change initiatives invokes a wide range of new
product opportunities for the chemical industry, including emission
treatments, additives and catalysts for cleaner fuels and fuel cells,
improvements in energy-efficiency through better insulation and lighter
weight materials, and new materials for solar panels and wind turbines.
On the other hand, the chemical industry is a large consumer of energy
as a raw material and in the refining process. Higher costs could come
for the industry from fuel prices as well as from the cost of complying
with greenhouse gas emissions requirements.
Telecommunications Services
„ A change in the head of the FCC along with Democrats’ preference for
network neutrality could be a positive for the smaller competitors at the
expense of the largest players.
Utilities
„ Coal is the dominant fuel source for power utilities. With the highest
proportion of costs attributed to energy of any sector, utilities are the
most exposed to any increased regulations on greenhouse gases likely
from Democrat-led executive and legislative branches of government.
Power utilities with relatively “clean” production from nuclear, wind,
hydro, and other renewable sources will have the advantage over those
that will need to undertake the costs of becoming “clean”. Even for
those companies at the forefront of environmental stewardship,
higher costs are likely.

25
 IMPACT OF WAS HI N GT ON

HISTORICAL PERSPECTIVE „ The exact emissions standards will be determined by politicians, and
ON CAPITAL GAIN TAX CHANGES that could be a lengthy process—consider the fact that coal-producing
Change Enacted Effective Date Appalachia has 12 seats in the Senate. Utilities are unlikely to commit to
Cut top rate from Nov 6, 1978 Aug 13, 1981 substantial outlays for new plants until the technical details are clear and
about 40% to 28%
they can safely adopt the technology best suited to the new rules. This
Cut top rate from Aug 13, 1981 Jun 9, 1981
28% to 20% delay may have the effect of slowing profit growth.
Hiked rate from 20% Oct 22, 1986 Nov 1, 1987
to 28% (cap gains Taxes in 2009
treated as ordinary
income) Income tax increases for the top wage earners may be coupled with tax
Cut top rate from Aug 5, 1997 May 7, 1997 cuts for the middle class in 2009. The investor tax cuts of 2003 that lowered
28% to 20% dividends and capital gains tax rates to 15% are likely to be at least partially
Hiked rate from 20% May 28, 2003 May 6, 2003 reversed in 2009.
to 28%
Source: “A Chronology of Postwar U.S. Federal Income Tax Policy” It is possible that the tax code changes which include income and dividends
by Shu-Chun Suan Yang of CAEPER at Indiana University, and Joint will be passed by mid-2009 and made retroactive to the start of the year.
Committee on Taxation However, we believe it is unlikely that a capital gains tax hike passed in 2009
will be made retroactive.
„ In 2003, the investor tax cuts were passed in May and made retroactive
to the start of the year, but the capital gains portion was not made
retroactive.
„ In 1993, the tax increase was made retroactive to the start of the year
after narrowly passing the Senate in August. However, this tax hike did
not affect the capital gains rate.
„ The one time the capital gains rate was increased in the recent past was
in 1986, and the effective date was not until the following year. Because
investors move to recognize long-term gains ahead of an impending
capital gains tax increase, setting the date for the increase produces a
near-term revenue windfall for the government.
While many investors may mourn the passing of the investor tax cuts of
2003, the market impact was difficult to discern given the geopolitical
and economic environment at the time. The impact of the reversal of
these provisions may be equally difficult to discern separately from their
macroeconomic context in 2009.
We can get a sense of this difficulty by looking back at the stock market’s
reaction to the news of a proposed investor tax cut and then the passage of
those cuts:
„ Initial details of the 2003 investor tax cuts began to appear in early
December 2002 with a statement from President Bush providing further
insight into the package of tax cuts on January 7, 2003. Stocks slumped
in December and January—even around the days details came to
light—as investors were focused on the impending invasion of Iraq. Non-
dividend-paying and dividend-paying stocks performed very similarly,
despite the prospects for a cut in the dividend tax rate.
„ Attention returned to the tax cuts in April 2003, as competing bills with
various provisions moved through both houses of Congress. There
was much uncertainty as to the final tax cut elements and whether any
investor-specific cuts were going to be passed.
„ The tax bill narrowly passed in mid-May 2003 with Vice-President
Cheney breaking the tie in the Senate. The package including the investor
tax cuts was signed by the President on May 28, 2003. In April and

26
 IMPACT OF WA S HI N GT ON

May (and over the rest of the year), the stocks of low- or non-dividend
High Dividend Paying Stocks Underperformed when
paying companies outperformed high- dividend payers as stocks rallied
Dividend Tax Cut Passed
powerfully and the invasion of Iraq got underway.
Performance of the top 20% and bottom 20% of stocks in
„ After passage, U.S. and non-U.S. stocks also performed very similarly, Russell 1000 Index by dividend yield.
with the world focused on Iraq. The impact of the investor tax cuts in the
High Dividend Payers
United States did not result in U.S. stock market outperformance. Also, Low Dividend Payers
low- and non-dividend paying stocks outperformed the high-dividend 70

payers that would be expected to benefit most from the lower dividend 60
tax rate. It appears that the tax cuts played little or no role in stock

Return (percent)
50
market performance. Possible reasons may be that investors discounted
40
the effect on future dividends since the cuts were not made permanent,
30
or that the effects on after-tax returns were deemed negligible relative to
the macroeconomic and geopolitical drivers. 20

In theory, stocks are valued by investors based on their expected total return 10

net of applicable taxes. For example, if dividend and capital gains taxes were 0

Apr-03

May-03

Jun-03

Jul-03

Aug-03

Sep-03

Oct-03

Nov-03

Dec-03
each set at 100%, stocks would have little or no value to a taxable investor.
It is reasonable to believe that the lower the tax rate, the more of the total
return on stocks the investor keeps on an after-tax basis, and the more the Source: FactSet, LPL Financial Research
investor would value the stocks. Looking at the post-WWII relationship
between investor tax rates and stock market valuations, based on trailing
price-to-earnings ratios, it is evident that stocks may have already priced in
an imposition of higher investor tax rates.
With Congress likely to push forward with legislation favoring higher tax
rates than those cited by Obama during his campaign, it is also worth
noting that the average price-to-earnings ratio was 12 during the mid-1980s
and mid-1990s, when the top capital gains and dividend rates averaged
about 35%. While many more issues than tax hikes are weighing on stock STOCK MARKET ELECTION REACTION HAS HAD
valuations, it appears that potentially even higher tax hikes would not THREE DIFFERENT PERIODS
necessarily lower valuations. Bold Lines Represent Years When Incumbent Lost
S&P Price
First Year Performance Performance
Market Performance Election Year After Incumbent Winning
During the year following an election, the markets have demonstrated some Average Return Year Election Party Party
impact from the election. Over the long-term, there has been no significant Year after Favored 1928 -11.9 R R
stock market performance difference in the year after a presidential election Challengers 1932 46.6 R D
Challenger = 46.6% 1936 -38.6 D D
based purely on which political party won the White House. Instead, the Incumbents= -22.8% 1940 -17.9 D D
stock market has been more likely to respond to whether the incumbent
1944 30.7 D D
political party won or lost. In the years after an election over the past 80 1948 10.3 D D
years, the stock market’s reaction has had three distinct periods. 1952 -6.6 D R
Mixed
1956 -14.3 R R
„ During the turbulent period of the 1920s, 1930s, and early 1940s that Challenger = 1.7%
1960 23.1 R D
Incumbents= 3.7%
included the stock market crash of 1929, the Great Depression, and 1964 9.1 D D
World War II, the stock market favored challengers over incumbents. 1968 -11.4 D R
1972 -17.4 R R
„ From the mid-1940s until the early 1970s, stock market reaction to 1976 -11.5 R D
the election outcome was mixed—neither favoring nor fretting over 1980 -9.7 D R
incumbents. Year after Favored 1984 26.3 R R
Incumbents 1988 27.3 R R
„ Over the past three decades, noted for above-average stock market Challenger = - 6.8% 1992 7.1 R D
returns and lengthy economic expansions, investors appear to have Incumbents= 18.9% 1996 31.0 D D
displayed a strong preference for incumbents. 2000 -13.0 D R
2004 3.0 R R
2009 may provide some insight into whether or not we are entering a new ? 2008 ? R D
era, wherein change is once again embraced by investors. Source: Bloomberg, LPL Financial Research
Past performance is no guarantee of future results.

27
 LP L FINANCIAL R E S E AR C H

IMPORTANT DISCLOSURES
The opinions voiced in this material are for general information only and are not intended to provide or be construed as providing specific investment advice or recommendations for any individual. To determine
which investments may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot
be invested into directly.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and are subject to availability and change in price.
Stock investing involves risk including loss of principal.
International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.
Small cap stocks may be subject to a higher degree of risk than more established companies’ securities. The illiquidity of the small-cap market may adversely affect the value of these investments.
High yield/junk bonds are not investment grade securities, involve substantial risks and generally should be part of the diversified portfolio of sophisticated investors.
Municipal bonds are subject to availability and change in price and subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise. Interest income may be subject to
the alternative tax. Federally tax-free but other state and local taxes may apply.
Government bonds and Treasury Bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value.
Investing in alternative investments may not be suitable for all investors and involve special risks such as risk associated with leveraging the investment, potential adverse market forces, regulatory changes, and
potentially illiquidity. There is no assurance that the investment objective will be attained.
Investing in real estate/REITs involves special risks such as potential illiquidity and may not be suitable for all investors. There is no assurance that the investment objectives of this program will be attained.
Investing in mutual funds involves risk, including possible loss of principal. Investments in specialized industry sectors have additional risks, which are outlined in the prospectus.
The market value of corporate bonds will fluctuate, and if the bond is sold prior to maturity, the investor’s yield may differ from the advertised yield.
An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although the Fed seeks to preserve the
value of your investments at $1.00 per share, it is possible to lose money investing in the Fund.
The Barclays Aggregate Bond Index is composed of securities from the Barclays Government/Credit Bond Index, Mortgage-Backed Securities Index and Asset-Backed Securities Index.
The Standard & Poor’s 500 Stock Index (S&P 500) is an unmanaged index generally representative of the U.S. Stock Market, without regard to company size.
Covered Call mutual fund strategies typically hold a long portfolio of stocks and then sell calls. Some covered call strategies then buy puts to further protect against downside risk. The net result is a portfolio that is
correlated to the broader markets, but with significantly less volatility and increased risk due to the use of derivatives.
Global Macro funds use fundamental inputs (focused on broad global economic themes) in their models as well as technical (or price related) inputs. Global Macro funds may also be less systematic than the typical
managed futures fund. Historically, the benefit of global macro has been solid long-term returns with very low correlation to equities and fixed income securities.
Long/short funds focus on managers who go long and hedge against the market through options or shorting equity securities with the goal of outperforming the market while limiting volatility. These funds tend to
have a higher correlation to equities than other alternative strategies and, therefore, are most appropriate for more aggressive portfolios.
Consumer Discretionary: Companies that tend to be the most sensitive to economic cycles. Its manufacturing segment includes automotive, household durable goods, textiles and apparel, and leisure equipment.
The service segment includes hotels, restaurants and other leisure facilities, media production and services, consumer retailing and services and education services.
Consumer Staples: Companies whose businesses are less sensitive to economic cycles. It includes manufacturers and distributors of food, beverages and tobacco, and producers of non-durable household goods
and personal products. It also includes food and drug retailing companies.
Energy: Companies whose businesses are dominated by either of the following activities: The construction or provision of oil rigs, drilling equipment and other energy-related service and equipment, including
seismic data collection. The exploration, production, marketing, refining and/or transportation of oil and gas products, coal and consumable fuels.
Financials: Companies involved in activities such as banking, consumer finance, investment banking and brokerage, asset management, insurance and investment, and real estate, including REITs.
Healthcare: Companies in two main industry groups: Healthcare equipment and supplies or companies that provide healthcare-related services, including distributors of healthcare products, providers of basic healthcare
services, and owners and operators of healthcare facilities and organizations. Companies primarily involved in the research, development, production and marketing of pharmaceuticals and biotechnology products.
Industrials: Companies whose businesses: (1) Manufacture and distribute capital goods, including aerospace and defense, construction, engineering and building products, electrical equipment and industrial
machinery, (2) Provide commercial services and supplies, including printing, employment, environmental and office services, (3) Provide transportation services, including airlines, couriers, marine, road and rail, and
transportation infrastructure.
Information Technology: Technology Software & Services, including companies that primarily develop software in various fields such as the Internet, applications, systems and/or database management and
companies that provide information technology consulting and services and technology Hardware & Equipment, including manufacturers and distributors of communications equipment, computers and peripherals,
electronic equipment and related instruments, and semiconductor equipment and products.
Materials: Companies that are engaged in a wide range of commodity-related manufacturing. Included in this sector are companies that manufacture chemicals, construction materials, glass, paper, forest products
and related packaging products, metals, minerals and mining companies, including producers of steel.
Telecommunications Services: Companies that provide communications services primarily through a fixed line, cellular, wireless, high bandwidth and/or fiber-optic cable network.
Utilities: Companies considered electric, gas or water utilities, or companies that operate as independent producers and/or distributors of power.
This research material has been prepared by LPL Financial.
The LPL Financial family of affiliated companies includes LPL Financial, UVEST Financial Services Group, Inc.,
Mutual Service Corporation, Waterstone Financial Group, Inc., and Associated Securities Corp., each of which is a member of FINRA/SIPC.
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